It didn't have to be this way. The financial crisis could have reset the stage for a sustainable investment landscape based on fundamentals, organic growth, and debt-free consumers who, when they aren't consuming are busy producing things for others to consume. But alas it was not to be. There was no purging of the toxic assets from the system -- instead they were bought by the Fed to the tune of some $1.2 trillion and a poisonous pile of bad mortgage backed securities was passed from the private sector to the public. There was no punishment for the financial sector -- their bad debt was swapped for shiny new dollars. Finally, and perhaps most importantly, there was no deleveraging -- total U.S. consumer debt outstanding is now just shy of an all time high.
Instead of producing a seachange, the collapse of 2008 has resulted in repeated attempts to show that problems created by financial irresponsibility can only be cured by recklessness on an even greater scale. It is as though the Fed has a point to prove to the market about its own omnipotence: we are so powerful we can cure a debt problem with still more debt. As a result, the credit bubble has been reinflated along with asset prices, interest rates have been stripped of all meaning, and capital markets are now entirely beholden to central banks. As former Reagan Office of Management and Budget director David Stockman put it in an interview on CNBC,
"The Fed (and the lunatics that run it) are telling the whole world untruths about the cost of money and the price of risk...They have destroyed the capital markets and the money markets; interest rates mean nothing; everything is trading off the Fed and Wall Street isn't even home."
Now, with the market hanging its hopes on more QE, it is worth considering how truly disconnected from reality this market has become. Consider the following chart which shows S&P 500 consensus EPS and S&P 500 P/E ratios:
Source: FactSet, Bloomberg via ZeroHedge
Note that the recent rally is entirely fueled by the expansion of P/E multiples (i.e. hope for more stimulus) as consensus 2012 EPS have fallen dramatically since May. Investors are paying no attention to expected earnings, they simply are buying to be buying and in the process bidding-up P/E ratios.
Next note that, as I outlined in a recent article, PMIs have collapsed worldwide of late as the eurozone debt crisis and slowing demand from China weigh on the global economy. In light of this, the following chart shows a weighted global PMI index plotted against an index of global equities:
Source: UBS, Datastream, ISM, Markit, MSCI, via ZeroHedge
As you can see, stocks have decoupled entirely from global manufacturing activity, surging to the upside while the weighted index of global manufacturing PMIs heads downward.
Similarly, the next chart shows the consensus global earnings growth forecast:
Source: IBES, Thompson Datastream, UBS, via ZeroHedge
Over this same period, U.S. equities (as measured by the S&P 500) are up over 11% as of Monday's close.
There simply is no fundamental basis for the current rally in U.S. equities. The market is trading entirely on stimulus hopes. Worse still, the Fed has created a bubble in both equities and Treasury bonds at the same time. Stocks are overvalued relative to the macro environment and once this week's Fed meeting is past, there won't be any more fuel in the tank in terms of QE-hope. Couple this with the fairly obvious fact that Treasury yields simply can't go much lower, and investors really are left with limited options (money market funds are hopeless given the threat of an IOER rate cut). It is because of these factors and because of what the 10-year breakeven rate is currently saying about inflation expectations (it touched 2.40 on Monday the highest since March), that I recommend investors increase the percentage of their portfolio allocated to gold (GLD) and consider short positions in U.S. equities (SPY).